April 24, 2023 | Premium Service | A reader of The Institutional Risk Analyst recently complained of seeking investment advice and specific thoughts and insights on preferred equity issued by small banks. First thought: Read our FAQs. Another thought: Ask Manny Friedman at EJF Capital how he feels about small lenders now that the fuss in financials has settled down a bit from last month.
EJF was the subject of derision in the media this past March because of the firm’s focus on small financials. But truth to tell, EJF started to pare back exposures last year. We ourselves decided to migrate up the capital structure in 2020, when the Fed began to “go big” with QE. This meant dumping common equity exposures and buying preferred equities. By the end of 2021, the bloom was off the rose in fintech and the shorts were already feasting on the likes of Upstart (UPST) and Affirm (AFRM).
The dichotomy in financials is profound. Smaller banks have better financial performance and growth, but suffer from the negative risk factor of liquidity. In March 2023, when the FOMC’s intemperate actions in the bond market caused several large depositories to fail, liquidity fled from smaller banks and nonbanks, leaving many investors specializing in smaller names underwater. If you invest in smaller banks, liquidity risk is the prime concern. It’s that simple.
The liquidity concerns of smaller banks are blissful, however, compared to the funding and operating profiles of nonbank financial firms operating in the world of consumer finance. Notice that UPST and AFRM continue to trade at steep discounts to our surveillance group.
Fact is, with SOFR just under 5% and the 10-year Treasury loitering around 3.5% this week, there is not a lot of juice in the nonbank consumer trade at present, especially with credit concerns weighing on more astute minds. Jumping funding costs for banks are the story of Q1 and Q2 2023, but credit will be the plat du jour by Halloween.
The big concern on everybody’s worry list is commercial real estate. We fussed about some of the existential issues facing New York City and other legacy urban landscapes during COVID, but the glacial pace of change in commercial real estate is finally starting to impact credit. Konrad Putzier just wrote a sobering article in The Wall Street Journal that begins to describe the carnage heading for the world of credit in commercial real estate.